Question

Which of the following statements is NOT CORRECT in the context of an Open Economy IS-LM Model under Floating Exchange Rate (with fixed price) and Perfect Capital Mobility?

• A. An expansionary fiscal policy would appreciate the domestic currency value
• B. An expansionary monetary policy would depreciate the domestic currency value
• C. Exchange rate has significant impact on determining the equilibrium level of income and employment
• D. Monetary policy is fully effective in determining income and employment whereas fiscal policy is ineffective

Answer 1

The Correct Option is C

To determine which of the given statements is NOT correct in the context of an Open Economy IS-LM Model under a Floating Exchange Rate with Perfect Capital Mobility, let's analyze each option based on macroeconomic theory.

1. Expansionary fiscal policy would appreciate the domestic currency value: Under perfect capital mobility and floating exchange rates, expansionary fiscal policy (e.g., increased government spending) leads to higher interest rates due to increased demand for funds in the loanable funds market. Higher interest rates attract foreign capital, appreciating the currency. Thus, this statement is correct.
2. Expansionary monetary policy would depreciate the domestic currency value: An expansionary monetary policy (e.g., reducing interest rates) decreases domestic interest rates, reducing capital inflow and increasing outflow, resulting in currency depreciation. Hence, this statement is correct.
3. Exchange rate has a significant impact on determining the equilibrium level of income and employment: In a basic model with perfect capital mobility, the influence of exchange rates on income and employment is overshadowed by the effectiveness of monetary policy. The primary tool in influencing income and employment is monetary and fiscal policy, not directly the exchange rates in such a model. Therefore, this statement is NOT correct.
4. Monetary policy is fully effective in determining income and employment whereas fiscal policy is ineffective: In this model, due to perfect capital mobility, fiscal policy is less effective because any fiscal expansion leads to currency appreciation, which neutralizes the effects on income and employment. In contrast, monetary policy is effective as it impacts interest rates directly without major exchange rate disruptions. Hence, this statement is correct.

Based on the analysis above, the statement that is NOT correct is: Exchange rate has a significant impact on determining the equilibrium level of income and employment. This is because, in a floating exchange rate system with perfect capital mobility, the effectiveness of fiscal and monetary policies primarily influences income and employment dynamics, while the exchange rate plays a secondary role.